The idea that investors act rationally has seemed to collapse along with the market in the last couple of weeks. “One of the things I think that is most irrational is to assume that we’re rational,” says MIT behavioral economist Dan Ariely, author of Predictably Irrational: The Hidden Forces That Shape Our Decisions. Today, he thinks that the same groupthink mechanisms that caused our financial catastrophe are keeping us from getting out of it.
He argues that it’s all a case of peer pressure: banks and public policy made it easy—even socially necessary—for people to borrow more than they should, which inflated housing prices. Then banks felt compelled to buy the mortgage-backed securities everyone else was buying. That didn’t turn out too well. The idea that the crowd is wise only works when everyone in the crowd is making an independent assessment, not when they are copying each other, he says. And one thing the crowd is feeling right now, he says, is the need for vengance. So, in order for our situation to improve, he thinks, some sense of moral proportion needs to be reestablished. In trust experiments, Ariely finds that people are willing to expend their own assets to exact revenge on those who cheated them—even if they will just end up losing more money. Which is why the bailout of Wall Street fatcats proved so politically unsatisfying. “When you think of $700 billion, the millions they made are not quite a drop in the bucket,” he says. “But we’re willing to lose money to get these bastards.” And that’s why the bailout hasn’t worked. “It didn’t answer the basic need of revenge. It could include future revenge—from now on, we’ll treat white-collar crime differently. Without that, I don’t see how trust is coming back.”
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